Structured to deceive?

I read an interesting article last week which stated that a few structured product providers were at the receiving end of their investors’ ire. These products were launched two years ago and garnered huge investor interest mainly because they were positioned as capital guaranteed products. Well, they did live up to the promise, in the sense that the investors recovered every penny of their initial investment. What left the investors feeling short-changed was the fact that they hardly earned anything beyond that in nominal terms (let alone in real terms).

The two reasons which were mentioned in the article are pertinent:

1. A low participation ratio: Such. products profess to offer the best of both worlds by not only guaranteeing the initial investment (This is ensured through investment of around 75% of the corpus in debt instruments) but also enabling investors to participate in a market rally (usually represented by the movement in a benchmark index such as the Nifty 50 or the Sensex). However, the extent of this participation is capped to the extent of 65-70% only. For instance if the Sensex was 10000 on the inception date of the product and it rises 20% to 12000 on the maturity date, the investor will earn 14%. This capping of upside leads to some investors feeling disappointed when they receive the redemption proceeds even though they may have been apprised of this aspect at the outset.

2. A more insidious reason for lower returns is theĀ high cost structure. The all-in costs for such products can reach as high as 40%, most of it going towards distributor fees. No wonder these products are popular among banks and other large distributors. High costs mean that investors begin the race with a huge handicap. More often than not, the returns subsequently generated are not enough to meaningfully overcome this massive hurdle.

Simplicity and low cost are two of the pillars on which a good investment product rests. Structured products often fall short on both these counts. These are usually opaque, high cost products which arepeddled at precisely the wrong time from an investor’s point of view. For instance investors are attracted to capital guaranteed products after a bear market is well underway and the fear factor is dominating. Distributors know this all too well. Hence when low valuations should be inducing you to aggressively invest either directly in equities or in a low cost mutual fund, distributors will approach you with such fancy products which benefit themselves and the product manufacturer more than you.

If at all you must invest in such products please go in for the ones with the low cost structures. After all while high returns cannot be guaranteed, high costs will surely guarantee that you will emerge a loser.

2 Comments

  1. Many investors invest in what they do not know or understand, often only for the novelty of the product. Capitalism is a good teacher, only a little costly for careless (and carefree) students. Simplicity, according to me, is a contrarion strategy.

  2. Thanks Amit.

    Yes. It looks like peddlers of financial products believe that “Simplicity” is found only in the dictionary of fools.

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